Published in Banking Law Journal, July 2002

The Issue of Right of Redemption in SBA 504 Lending

by Thomas Wallace and Gregg Lehrer

The impact on lending institutions, notably community banks1, of the exercise of the Right of Redemption, under the U.S. Small Business Administration’s (“SBA”) 504 Loan Program (the “SBA Loan Program”), can be profoundly detrimental to both, participating financial institutions and to the potential borrower under this SBA Loan Program.

“Right of Redemption”2, is the legal principle whereby, the SBA as a Federal Agency, can redeem a senior creditor’s interest in an asset to assert and protect the interest of the federal government, in the case of the SBA, for a period of one year, after the creditor has gone through all normally required legal processes to gain control of the asset. Many states have enacted legislation which would attempt to eliminate the federal government’s Right of Redemption. However, a state’s ability to circumvent 24 U.S.C. 2810 was squarely addressed by the Supreme Court in United States v. John Hancock Mutual Life Insurance Company.3 Relying on the Supremacy Clause of the United States Constitution, the Supreme Court held that the federal government’s Right of Redemption is paramount against state law, which conflicts with the one-year redemption period4.

The 504 Loan program of the SBA is a less known financing vehicle; despite having involved the financing of projects with a total cost approaching six billion dollars and the creation of up to fifty thousand jobs in the past year. The focus of the 504 is the purchase or construction of capital assets, while requiring minimal equity from borrowers. The borrower will be required to inject into the project, ten to twenty percent of project cost. During construction or, as regards equipment, delivery and installation, the bank will fund the entire balance of the project cost. Within approximately thirty to sixty days of completion a SBA sponsored vehicle will provide takeout financing reducing the bank’s exposure to approximately fifty percent of the project cost, with an upper dollar limit to the takeout of $1MM to $1.3MM depending on specific circumstances. The bank’s financing will be in a first security position with the SBA supported financing junior to the bank in security interest. At no time in the process, does the bank enjoy a guarantee from the SBA, the program simply commits to reducing the final exposure to a very low loan to cost ratio.

The appeal of the 504 program to lenders is in its enhancement of the Loan to Cost ratio, and thus the reduced likelihood of lender loss. However, this enhancement is only as effective as the mechanics, which deliver it. A liberal implementation of the Right of Redemption would reduce the perceived value of the enhancement and would lessen the appeal of the program among lenders, particularly community banks. This would limit the distribution and impact of an otherwise extremely successful program. Furthermore, it would work contrary to both the SBA's and the debtor’s interest, in seeing a maximized sale value of the property, which could benefit both, as outlined below.

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When SBA decides not to bid on real property at a courthouse auction, it is implicitly acknowledging the limits to both the potential recovery, and the resources required to obtain such. At this point SBA is making an economic decision and accepting a loss. The lender, by acquiring the property, is accepting the risk that there is sufficient equity, and the prospect of a ready market for such, to justify the expenses and difficulties, both financial and regulatory, inherent to the situation. Overall, SBA accepts a defined downside and the lender opts for an attempt at a full financial recovery. It is realistic to consider that at the roughly 50% Loan to Cost basis of the 504 program there is every reasonable expectation of such a recovery. There is also the possibility of an additional gain, as the proceeds of a sale in excess of the debt and costs go to the benefit of the Lender, as the holder of the foreclosure judgment. The possibility of the Lender achieving such a gain is limited by the regulatory pressure, which they will encounter in such a situation. It is thus conditioned by the willingness of the Lender to endure such regulatory pressure and the ability to bring largely local resources; community knowledge, contacts, and local staff; to bear in marketing the property.

Under present bank regulatory postures, if a property is taken back and classified as “Other Real Estate Owned” (OREO), it must appraised, and the carrying value on the bank’s books being adjusted, generally downward, to the current appraised value. Regulatory expectation is that within six to eight months the property will be sold, or if it is not, further write-downs will be mandated, now coming from current period operating earnings, as opposed to previously established loan loss reserves. The pressure will be increased by the impact that such a transaction would have on the ratio of criticized assets to capital. For example, in a bank with equity sufficient to be classified as an "Adequately Capitalized" bank with $70 million loan portfolio the classification of a $500M OREO parcel would, in and of itself, raise the ratio of criticized assets to capital to 8.9%. Ten percent (10%) is considered a critical performance benchmark by many regulatory bodies. Such a development would certainly lead to increased scrutiny of overall loan loss reserve adequacy and portfolio management. This could lead to additional reserving actions thus further decreasing current period earnings. Given the proportions the concern is greatest for the literally thousands community banks, as defined earlier, participating in the 504 program. (It is estimated that for the most current year’s statistics the percentage of banks participating in the 504 program which meet this definition is thirty (30) percent. )

By implementing the fullest sense of the Right of Redemption the SBA provides both a hurdle against and a powerful disincentive to the Lender to attempt to maximize the selling price of the property. The SBA creates a cloud on the title6, which will limit the marketability of the property. Such limitation reduces both the ability and the incentive to the Lender to resist regulatory pressure to dispose of the property as rapidly as possible. Clearly, these actions will limit the possibility of achieving the maximum value.

In sum, it is the perfect incentive to sell the property as rapidly as possible at the most readily "acceptable", read "lowest", price. This has no benefit for the SBA, since the SBA would have no incentive to redeem the creditor’s position, and could promote the perception among lenders of being unfair dealing as the lending institution is asked to bear risks and consequences and yet reap no rewards. There is no benefit to the lender as at best, they are given the thankless job of managing a foreclosure. Nor do the debtors or guarantors benefit since a reduced asset price, absent debt relief will create larger deficiency judgments. The particularly insidious aspect of Right of Redemption implementation as portrayed above, is that the promotion of the SBA504 program is heavily based on the benefit to the private sector lender of being in a strong senior lien position to a co-operative junior lien-holder. When the mechanics of the program interfere with this premise they go directly contrary to the understanding actively promoted among all product users.

This can be mitigated by defining a range of formulas allowing for a release of the Right of Redemption with an equitable sharing of the tradeoffs between upside, downside, resources and regulatory burdens. Rather than relying on the potential exercise of the Right of Redemption to occasionally increase its recoveries SBA could waive the right for a choice of:
a) A defined percentage of the existing lien position
(This would allow SBA to recover some money for its troubles in a situation, but would also allow a rapid closure and a minimal commitment of SBA staff resources. A good analogy might be a transaction breakup fee.)
or
b) A defined percentage of the net recovery after the payment of the full lien position and all expenses associated with the credit and its recovery.
(This would provide the lender with the incentive to resist regulatory pressures, and to bear the significant intangible costs of OREO management, while allowing SBA to participate, with minimal expense or effort, in any recovery generated through the lender's local knowledge, efforts and resources. A good analogy might be an oversized finder's fee.)

The Chart below provides an example of the proposed alternatives:

Example of Release Calculations
Original Project Cost $1,000,000              
Project valuation at Completion $1,150,000         Entrepreneurial Factor 15.00%

Original Loan Structure                
Private Sector Lender First REM $500,000         Participation Percentage 50.00%
SBA Supported Second REM $400,000             40.00%
Borrower Initial Equity $100,000             10.00%

Range of Probably Recovery                
Loan to Cost   60.00% 75.00%   Loan to Value 50.00% 65.00%
  Midpoint   67.50%         57.50%
  Probably Recovery   $675,000         $661,250
        Midpoint
$668,125  

Recovery Costs                
Legal Foreclosure Costs   $7,500            
Appraisal   $2,500            
Marketing/Brokerage   $66,813            
Maintenance   $5,000            
Taxes   $2,500            
Default Interest 8.00% $20,000            
Holding Prd. (Months) 6            
        Recovery Cost
$104,313  
        Recovery before SBA Release Fee $563,813

Fixed Release Fee                
2.00% of First REM Value $10,000            

Participation Release Fee              
10.00% of Net Recovery $56,381 with ceiling        
              Fixed Participation
        Net Recovery to Lender $553,813
$507,43

Net (Chargeoff) or Gain    
Fixed Release
Participated Release
 
    Lender
$53,813
$7,431
 
      SBA
$(390,000)
$(343,6916)
 
                 


The chart lays out a SBA 504 transaction in terms of national averages, from original cost and valuation estimates through funding and finally derives an estimate of a gross recovery in a liquidation of the property.

The percentages used in the calculation of the “fixed release fee” and the “participatory release fee” are merely, examples in specificity, to demonstrate the logic of the argument. The “fixed release fee” is a walk-away fee to the SBA and is paid where the SBA determines that while there is some likelihood of recovery the potential does not merit the full commitment of resources to buy through the senior secured position. Such a fee, which could be set as a national standard, should be by its nature minimal and should be easily recovered in the post foreclosure sale, thus posing no issue to the lender. Being a minimal amount it does not act contrary to the interests of guarantors of the debt, as it would have limited impact on the dimensions of a deficiency. The percentage used, for this example, in the participatory release fee is pure supposition. This fee should be determined on a case by case basis, within a range, say ten to thirty percent of recovery after expenses, set by national policy. Decision criteria would have to be defined to determine which of the two courses would be appropriate, though this decision should be left to local SBA district offices whose specific regional and transactional knowledge should produce superior results. A starting point of the decision would logically be a valuation of the real property and an estimation of likely recovery. Should the valuation incline to a likely gross recovery of less than ten percent, the fixed release fee scenario would be pursued. If the likely recovery is greater then ten percent, but below an upper limit to be determined, the participatory release fee would be pursued. The specific participatory release fee, would then be negotiated between the lender and the SBA, in the context of a negotiation for an offer in compromise with any guarantors, between a predetermined range, say of ten to thirty percent of the net recovery. Should the likely recovery exceed the determined upper limit, SBA would act as a typical junior creditor in a foreclosure environment to protect its interest.

This begs the question of how to resolve the obligations of guarantors against the deficiency created from the SBA’s creditor position. Prior to the finalization of an agreement between the lender and the SBA, an “Offer in Compromise”7 must be reached with the guarantors. This will preclude any claim of a violation of the covenants of good faith and fair dealing, or that the Lender’s actions were commercially unreasonable, in disposing of the asset. There are clearly benefits to the debtor and third party guarantors by speeding the process, which will allow a discharge of the debt or contingent liability and allow them to move on. The details of the Offer in Compromise will depend, in some degree, on the evaluation of the strength of the guarantors. A decision would be based on a trade-off between the final loss to the SBA as a junior creditor and ability to resolve the obligation with minimal costs, minimal staff resources, and minimal time expended.

Any external factor, which increases uncertainty, is a threat to commercial lending operations. This is amplified when under the aegis of a risk mitigation program such as the 504 Loan Program, the mechanics of foreclosure and recovery are complicated by the very implementation of the program. To simply continue the policy of subjective use of the Right of Redemption is to discourage the use of the 504 Loan Program, a program the benefits of which are well documented. The proposal resolution allows for an orderly and predictable handling of this issue. By offering a choice of alternative recovery modes in waiving the Right of Redemption, while not precluding the SBA’s ability to act as a junior lienholder in foreclosure actions, it allows for maximum flexibility and local decision making. Intuitively this should maximize the overall recovery rate, which further lowers program costs, in a program which is already arguably the lowest delivery cost government based commercial loan program. As a general policy, and not a program revision, it does not require a change in statute or other legislative action. It is thus relatively straightforward to implement and the benefits accrue to all parties. The SBA obtains in the aggregate, a predictable stream of revenue to offset ordinary lending losses and recovery costs while preserving program integrity. The lender obtains a simplified recovery posture, with possible recovery of costs and gains commensurate to risks and burdens. Finally, the debtor and any third party guarantors are allowed to close a painful chapter in their professional and personal lives.

Notes

1 The Independent Community Bank Association defines a ‘community bank” as one with assets of less than one billion dollars. Fifty-eight percent (58%) of all current bank charters in the United States meet this definition.
2 The Right of Redemption in favor of the federal government was established on June 25, 1948 and subsequently amended on November 2, 1966 in 28 U.S.C. 2410(c) and provides in relevant part that “Where the sale of real estate is made to satisfy a lien prior to that of the United States, the United States shall have one year from the date of sale within which to redeem, except that with respect to a lien arising under the internal revenue laws the period shall be 120 days or the period allowable for redemption under State law, whichever is longer . . .”
3 United States v. John Hancock Mutual Life Insurance Company 81 S. Ct. 1 (1960)
4 The Court reasoned that Congress considered the Right of Redemption to be “an important and integral feature of Section 2410”, such that the United States would have the opportunity to protect its interest in foreclosed property.
5 Wallace, Thomas. “SBA 504 Loans: An Underused Product That Helps Community Banks.” RMA Journal April 2001: 26-31.
6 The cloud on title will always be present in this event due to the fact that the Right of Redemption vests in the SBA and remains for a period of one year. During the time that the lender is actively marketing the property, any potential purchaser will demand clear title and a title insurance policy insuring the purchaser’s fee simple title. A title insurance underwriter, seeing that the property was the subject of a foreclosure of the federal government’s interest, will always take exception for the rights of the SBA as an agency of the federal government to exercise its Right of Redemption pursuant to 28 USC 2410. Absent a written, recordable waiver of the SBA’s Right of Redemption, the foreclosed property cannot be conveyed with “clear title”.
7 An Offer in Compromise in SBA parlance is an agreement between the lender, borrower and guarantors whereby the parties agree on how to dispose of the asset and minimize loss.

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